What is Cost Averaging?

In a marathon, participants are advised to go easy on sudden bursts of high speed during the race, especially at the beginning. This may sound confusing. How can one win such a long distance without speed? However, running at full speed would be pointless if the participant loses stamina mid-way. 

Similarly, investors gain when they are steady and consistent even in volatile situations instead of looking at high-speed sprints. We all have heard that one should buy more when the market is low and reap profit when the market is high. However, with limited time, resources, information, and skillset it gets very difficult to time the market and actually buy and sell with every dip. In fact, there are costs such as brokerage, taxes, and STT involved when you buy and sell with every small change. These costs would eat into your profits. So what is the easiest way to make use of the saying and buy more when markets are at a low and less when markets are at a high? 

 SIP (Systematic Investment Plan) is one of the best modes to invest in such a situation. Let us understand this better with an example.

What is cost averaging? 

The concept of cost averaging lies in averaging out the cost at which you buy units of a Mutual Fund. it guides the investor to - buy- low and sell- high’. However, at times an investor ends up doing just the opposite. By investing on a fixed schedule, you avoid timing the market and figuring out the exact best time to invest. Cost averaging helps you to take advantage of market volatility. 

How does SIP help with averaging?

Take a look at the following table to understand the concept better:

Date NAV Unit Amt
Dec-19 524.64 9.530345 5000
Jan-20 525.27 9.518914 5000
Feb-20 509.31 9.817204 5000
Mar-20 468.77 10.66621 5000
Apr-20 348.51 14.34679 5000
May-20 409.96 12.19631 5000
Jun-20 405.4 12.3335 5000
Jul-20 429.29 11.64714 5000
Aug-20 446.72 11.19269 5000
Sep-20 467.35 10.69862 5000
Oct-20 449.9 11.11358 5000
Nov-20 455.46 10.97791 5000
Dec-20 522.39 9.571393 5000
Jan-21 560.57 8.919493 5000

Total Investment: INR 70,000

Total Number  of Units: INR 153

Profit: INR 15,504

 

If the same amount i.e INR 70,000 was invested by lump sum route in December 2019, one would have earned a profit of only INR 4,794 in Jan 2021.

In the above example, we can see that SIP helps us to reap more profit in comparison to lump sum due to cost averaging. We often hear people saying buy more when the market is down, but one cannot time the market and invest according to it. 

 

You can refer to the following articles to know more about SIPs: 

SIP Impact: Well Illustrated

Timing the market for your SIP investments?

Should I pause/stop my SIP?

 

Wealthcafe Advice:

We recommend you invest based on your asset allocation. As said earlier, one cannot time the market, however asset allocation will help you to buy and sell accordingly. If the ratio of equity: debt changes by 10%  it is time to revisit and rebalance your portfolio. This will help you to buy- low and sell- high. You can read this article - How am I investing in current times - Akruti Agarwal- to understand how asset allocation helped me to earn profit during a pandemic situation. 

 

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    FMP? - Know everything about Fixed Maturity Plan

    Many of us want to invest in instruments that are not very risky and generate good risk-free returns. Here comes the concept of investing in Fixed Maturity Plans (FMPs). 

    What are FMPs?

    These are closed-end debt funds, sold as if they were replacements for multi-year fixed deposits. The idea was:

    • You bought a fund
    • The fund bought some debt securities scheduled to mature in a certain period say 3 years.
    • After three years, the fund gave you back the maturity amount minus their fees and all that.

    FMPs invest in commercial instruments, highly rated corporate bonds, and various money market instruments. The basic rule in the FMP is to park money in an instrument that has a similar maturity date.

    Features of FMPs

    1. Fixed Maturity - The maturity period of an FMP is fixed and once you have invested through NFO (new fund offering), your investment is essentially locked in till maturity. The maturity period of FMPs is usually more than 3 years from the date of unit allocation. This ensures that indexation benefits can be obtained on FMP investments. Read more about indexation and capital gains here
    2. Reduced Interest Rate Risk - FMPs are least exposed to interest rate risk, as the fund holds instruments till maturity-getting a fixed rate of return. Interest rate risk indicates that whenever there is a change in the interest rate, the value of the underlying security and hence, the NAV of the fund would change (more or less) depending on the movement of interest. Locked-In Rates: While locked-in rates are an excellent choice during a falling interest rates regime, the same can become a problem during a period of rising interest rates. When market rates move upwards, locked-in rates can lead to missed opportunities concerning potentially higher returns coupled with possibly lower risk levels. You can learn more about it here -NM 104: Basics of Mutual Funds
    3. Low Liquidity - FMPs are not liquid, you cannot withdraw before the completion of full tenure. So, if you invest in an FMP of 3-year tenure, you can withdraw only after 3 years and not in between. 
    4. Lower tax liability - A majority of new FMPs feature a maturity period of 3 years or more. This ensures that long-term capital gains tax rules including indexation benefits apply to capital gains from these non-equity investments. Indexation provides investors with the benefit of factoring in inflation, which reduces overall tax liability on gains. Read more about mutual fund taxation rules
    5. Returns Not Guaranteed: Fixed Maturity Plans provide investors with the benefit of locked-in returns from instruments held till maturity and high-quality investments minimize the credit risk for investors. That said, the low potential risk does not mean zero risks for the investors, and returns from FMPs are still market-linked. As a result, returns from FMPs are not guaranteed unlike other fixed return instruments such as fixed deposits.
    6. Not similar to fixed deposit
      Comparison Criteria Fixed Maturity Plans Fixed Deposit
      Returns Market – Linked Returns Guaranteed Returns
      Taxation Capital Gains Taxation Rules apply to the  benefit of indexation Interest is taxed as per the Income Tax slab rate of the investor
      Liquidity Low Liquidity Premature withdrawal options and sweep-in fixed deposits make it very liquid.
      Maturity Options Varies for each scheme (typically 3-4 years) Varies by a bank (typically 7 days to 10 years)
    7. Banks waive penalties

    On the other hand, an increasing number of banks are not levying any penalties on premature withdrawal of fixed deposits. The State Bank of India, for instance, does not charge any penalty on premature withdrawals from short-term deposits of Rs 15 lakh and above after seven days.

    In cases of tenure of more than one year, there is a small penalty. The deposit earns 0.5% below the rate applicable for the period the money remained with the bank or 0.5% below the contracted rate, whichever is lower.

    This makes bank FDs a better proposition for those in the lower tax brackets. The tax on FMPs will only be marginally lower and not make a significant difference for someone who earns less than Rs 5 lakh a year. Even though the tax will be higher on FDs, they will offer greater liquidity to the investor.

    What are the things you must check before investing in an FMP?

    While FMP offers several advantages over other fixed-income products, there are still certain factors that investors should keep in mind before taking the plunge. Here are a few of them.

    • Check Indicative portfolio:  If the indicative portfolio shows the portfolio will invest the majority of the corpus in bank certificates of deposits (CDs), then the portfolio may have lower risks compared to FMP’s which invest predominantly in Commercial Papers (CPs). Seen from the other side, having Commercial Papers in the portfolio may mean slightly higher rates. So as an investor before investing in an FMP you should have a clear idea about the risks you are willing to take and how does the portfolio looks like.
    • Credit rating of the securities:  You should also check the scheme’s offer document for the minimum credit rating of the securities the fund intends to invest in. The investors should also note that the higher the credit ratings of their securities, the lower the returns would be for the FMPs and vice versa. However, lower credit rating securities have higher credit risks; hence investors should keep in mind the same. Credit risk indicates the risk of default. 
    • Expense Ratio of the scheme – Investors should select a scheme that has a reasonable expense ratio as per the tenor of the FMP, as a higher expense ratio reduces the overall yield on the FMP.
    • Maturity of the Scheme: Some of the FMPs launched between January and March every year offer double-indexation benefits. Double Indexation helps reducing long term capital gains thereby reducing overall tax liability

    TAXATION OF FMPS

    As FMPs are a type of debt fund, they are taxed like other debt funds. Investments held for more than 36-months are taxed at the rate of 20%. But there is an indexation benefit available here. With indexation, you get to increase the purchase price of FMP units in accordance with the inflation during the period. This helps in reducing your taxable returns from FMPs. Do note that tax-saving FDs falling under 80C do not allow premature withdrawal. Where FMPs score over FDs is indexation benefit, which results in paying lower taxes.

     

    Who Should Consider Fixed Maturity Plans?

    Investors who are looking for higher returns in comparison to FDs and RDs and are willing to accept frequent market fluctuations can invest in FMP’s. Additionally, investors must be willing to lock in their funds for a time period of 3 years. In a bid to provide higher income to their investors, FMPs invest in instruments that bear some credit risk so ensure that you understand the risk when you invest in FMPs and do not invest in them as a replacement for fixed deposits.

    Separately, for all your emergency funds - we would advise you to continue to invest in fixed deposits or liquid mutual funds. For short-term goals of up to 3 years - you can invest in short-term debt funds or could consider FMPs. But do remember that FMPs come with Fixed Tenure and hence, you cannot access it unless the tenure is completed.

     

    Consult your financial advisor to understand how these funds fit into your risk appetite and goals. We are SEBI registered investment advisors and can help you make sound investment decisions - you can reach out to us at iplan@wealthcafe.in, in order to help you make a financial plan for yourself.

    To learn more about Asset classes enroll in our course NM 103: Basics of Asset Classes

    You can also check our course on Mutual Funds NM 104: Basics of Mutual Funds

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